The LTV: CAC ratio is considered to be the heart of any demand generation team. We’re sure you’ve already implemented LTV and CAC calculations into your monthly sales and customer success reviews, however, we’re going to give you some context and tips to take these two vital metrics into overdrive! So, are you ready to vamp up your sales and customer success efforts with the LTV: CAC ratio?
“Customers are costly – Not managing your CAC is like maintaining your Ferrari’s exterior with shower gel!”
In this article:
- What is CAC
- How to calculate CAC
- What is LTV
- Customer Lifetime Value formula
- LTV: CAC ratio
- Challenges faced by the LTV: CAC ratio
- How to get the most from LTV: CAC ratio
- Limitations of LTV: CAC ratio
- LTV: CAC ratio presentation
What is CAC?
CAC stands for Customer Acquisition Cost. It is one side of the coin that helps us understand what we are achieving from the investments that a company has been spending on its demand generation efforts to acquire new customers. Unlike one-hit-wonder brands, companies need to keep getting new customers to keep the business running. This metric is the one to rule them all and can be used inter-departmentally to compare which department is generating the most affordably acquired customers.
How to calculate CAC?
CAC is an easy formula, which is: total money spent on sales and marketing divided by the number of customers acquired (below 👇). The money spent on sales and marketing includes the salary of the marketing department, advertising costs, other related expenses of your sales representatives, and all other marketing, sales, and customer service expenses.
CAC = Cost of acquiring new customers / # of new customers
If the customer acquisition cost is exceeding your revenue, there is no surprise that the company will likely soon go out of business. Let’s understand through an example. Let’s say that a company is putting out two ads to acquire customers. You spend $100 on one of the ads and are spending $200 on the other ad. The first ad manages to get 5 customers, so your CAC will be $20. The second ad also gets 5 customers; in this case, your CAC will be $40.
You can notice with the second ad they are spending more money but are acquiring the same number of customers. This way, the company can calibrate its investment by either modifying the second ad or by pushing the first ad to more customers. CAC is, therefore, important because it lets us calibrate our investment strategy in a way in which we can get the most return on the money spent. It also helps in figuring out the LTV: CAC ratio. What is this new ratio now? Be a bit patient; we are getting there!
What is LTV?
Before we dive into the LTV: CAC ratio, we must understand what LTV means. LTV stands for Lifetime Value, which means the revenue that the company has generated from a single customer over a certain period. This period varies according to the vertical, business model, and so forth. The time frame in question is from 1 year to 5 years, but it can be longer depending on your vertical.
Customer Lifetime Value formula
There are various LTV formulas out there to help you reach the LTV: CAC ratio. The most common formula is the average number of orders multiplied by the average cost per order multiplied by the time the customer has been with the agency. You can also check out this above infographic or the below formula.
LTV = average value of a sale x Number of transaction x Retention period
CLTV = LTV x Profit margin
The figure that we get from this formula is not only helpful for figuring out the LTV: CAC formula but also assists to shed light on strengths and weaknesses in the business. LTV shows us the path of revenue generation. A company can generate comparatively better revenues if it manages to retain customers effectively and increase its LTV, rather than only focus on acquiring new customers.
LTV also introduces us to the concept of incentivizing existing customers for staying with the company. The goal is to increase their spend or retention period, therefore the average LTV for your customers.
LTV: CAC ratio
LTV and CAC are both extremely useful formulas on their own, however, the LTV: CAC ratio is where the secret sauce really is! The simple formula for LTV: CAC ratio is LTV divided by the CAC (infographic above, formula below!).
CAC: LTV ratio = CLTV / CAC
Enough about the mathematical calculations; let’s get down to brass tacks now. An LTV: CAC ratio of 3-5 is considered good for a successful company. In other words, a company is recommended to spend 1/3rd of the customer’s lifetime value on acquisition and retention of the customer. Additionally, this metric further helps demand generation teams to evaluate the best channels to spend their marketing and sales dollars, by setting strict CAC limits, according to the LTV: CAC formula and the LTV value of their customers.
Challenges of the LTV: CAC ratio
There are two major challenges that one might face while calculating LTV: CAC ratio. Well, to put it into words, the biggest strength of this ratio is also one of the biggest weaknesses. What do we mean by this now?
Firstly, calculating CAC can be challenging at times. It is difficult to calculate exactly how much we spent on acquiring a customer. This is due to the sheer volume of touch-points it requires to acquire a customer, therefore granular CACs can be difficult to attirbute to different demand generation channels.
Similarly, calculating the LTV is not that easy. The formula for LTV varies from company to company, as the nature of the business also varies. Some companies have a large customer turnover ratios due to their nature of business. In some other cases, the company might be in a seasonal business, which means they will have to modify their retention period formula. Therefore, when evaluating your business LTV, it is important to compare against the same vertical, business model, geography, and other important customer and business demographics and categories.
In summary the LTV: CAC ratio is useful as it connects the lifetime value along with the customer acquisition costs to give us a better understanding of the effectiveness of the company’s business model and demand generation efforts.
How to get the most from the LTV: CAC ratio?
Here are some tips to get the most out of your LTV: CAC ratio, and to not make any mistakes!
- As mentioned above, it is important to compare against the correct industry standards for CAC and LTV.
- All of the metrics discussed in this article are only useful when analyzed over a long period of time, in order to evaluate how various business decisions and functions affect the bottom line.
- Many companies fail to incorporate their wage costs associated with acquiring new customers, which is essential in calculating an accurate CAC.
- Depending on the company’s business model and existing surplus, one tactic to improve profitability is to recover the cost spent on acquiring the customer as an upfront cost from the customer
- Managers can use the LTV: CAC ratio-metric to analyze the acquisition rate of the customers and arrange the resources to help retention. Customer service will be one of the most crucial services when the customer turnover rate starts increasing drastically.
- The large inflow of customer requests and complaints can be routed through the customer service department to optimize the flow of business. You must be wondering how this is related to the LTV: CAC ratio. Well, with higher customer inflow, the amount you spend on customer service will also increase, which means you have got new components to add to the CAC calculation. The LTV: CAC ratio will help you figure out how much more you should be spending on managing the customers.
Limitations of the LTV: CAC ratio
Even though the LTV: CAC ratio is one of the more important indicators that help the company with predictions for future growth, it is susceptible to drastic and sudden changes. For example, a new competitor can increase customer churn, or ad spend (for example, a new competitor might start bidding on your keywords!). Therefore, it is important to constantly monitor your LTV: CAC ratio, and update it frequently. We recommend at least monthly!
Additionally, as mentioned above, it is important to be aware of the different industry standards when it comes to LTV and CAC metrics. You can check out the infographic above, for the kinds of industry comparisons, you should be looking into.
A quick LTV: CAC ratio summary
If you’re more of a visual learner, or you want to refresh everything we’ve just covered, then there is an awesome presentation made by ProfitWell (above) that recaps everything you should know about LTV: CAC ratio!
Final thoughts on the LTV: CAC ratio
For an investor, LTV: CAC ratio is very important. They can judge the profitability of the company through this ratio and will decide whether they want to invest in it or not. Businesses know that a good chunk of their invested money will be used in acquiring customers and ensuring their retention. This can help them better allocate their resources and optimize the flow of money, including the hiring process and the salaries of the marketeers.
However, the most important thing to remember when calculating the LTV: CAC formula is consistency! Consistently use the same formula to calculate this, and keep to the same cadence of updating these statistics.
Looking for other ways to vamp up your sales and customer success cycle? For sales professionals, we have our guide on mastering the infamous MEDDIC methodology, that helped grow PTC by 90% in revenue! For customer success professionals looking to improve their NPS, check out our guide on that here!
